Capital Gains and Losses

2024-04-19Capital gains and losses result from the sale or other disposition of either business property or investment property, such as real estate, stocks and bonds, and collectibles. Gains from personal property are taxable, but losses are not deductible. Short-term capital gains are taxed at ordinary marginal rates, while long-term gains are taxed more favorably, depending on the type of property and the income of the taxpayer.

There are 4 advantages to taxpayers of capital gains taxes over the taxation of income earned from work:

1. no employment taxes are assessed on capital gains, although the Medicare surcharge of 3.8% applies for higher income taxpayers;
2. the maximum long-term capital gains tax rate on property held longer than 1 year, equals the lower of the taxpayer's marginal rate or the long-term capital gains rate, which is a maximum of 20%, depending on taxpayer income, for many assets, including stocks and bonds and other financial instruments, + a 3.8% Medicare surcharge for higher income taxpayers;
3. gains are not taxed until they are realized, i.e., when the property is sold; some taxes, such as on real estate, can be deferred even further through tax-free exchanges of property; and
4. capital gains may escape taxation completely if the property is bequeathed to heirs, because the tax basis of the property, which is subtracted from the sales price of the property to determine the gain, is stepped-up in basis to its value when the death occurred (of course, if the property loses value, then its value is stepped down)

Whenever property is disposed of, such as in a sale, the seller may realize a taxable net capital gain or deductible loss. Realized gain or loss = the realized sales price minus the adjusted basis of the property.

Realized Gain or Loss = Amount Realized From Sale − Adjusted Basis of Property

The amount realized from a sale is the sale price minus any direct selling expenses, such as commissions or brokerage fees. The adjusted basis of the property includes its purchase price + any direct buying costs, such as commissions or fees.

Recognized gain is the amount of realized gain includable in the taxpayer's gross income; recognized loss is the amount of realized lost that is deductible.

Realized gains or losses for nontaxable exchanges are not recognized; instead, gains or losses are postponed by assigning a carryover basis to the replacement property. The tax code refers to this as a nontaxable disposition, or a deferred-tax disposition. For instance, if you exchange property in which you have a $15,000 basis but that has a fair market value of $20,000 for other property that also has a fair market value of $20,000, then your basis in the new property is the $15,000 of the replaced property. So if you sell the new property for $22,000, you will have a recognized gain of $7,000. By contrast, a tax-free transaction is never recognized.

Special rules, which are discussed elsewhere, apply to the sale of mutual fund shares, tax-free exchanges of property, the sale of a principal residence, and sales of stock rights, wash sales, and short sales.

Capital Assets

The Internal Revenue Code defines a capital asset as any property not listed in IRC §1221 — §1221 includes inventory, accounts receivable, and depreciable property or real estate used in business, the disposition of which usually results in ordinary income or loss for the business. Other business assets, sometimes called §1231 assets, result in ordinary gain or loss, reported on Form 4797, Sales of Business Property.

Tax law excludes certain assets as capital assets, including copyrights, musical or literary works, letters, memoranda, or other property that the taxpayer created with his own efforts or was acquired as a gift from someone who either created the property or had it prepared or created. This comports with the de facto tax policy objective of favoring the wealthy, by taxing work more heavily than investments, since assets created by one's effort will not benefit from the lower long-term capital gains tax. On the other hand, if someone bought a musical or literary work, then that asset will be treated as a capital asset, which may benefit from the lower long-term capital gains tax rate.

Collectibles are a special type of capital asset, which includes art, antiques, metals, gems, stamps and coins, bullion, and even alcoholic beverages that are held as investments. The long-term tax rate for collectibles is the lesser of 28% or the taxpayer's marginal tax rate; short-term gains are treated as ordinary income. So if a taxpayer in the 15% bracket sold a collectible, the gain would be taxed at 15% at most, regardless of the holding period. Other types of capital assets may also have different tax rates:

The net profit earned from selling property depends on its tax basis when sold, which is adjusted for capital additions or depreciation.

The tax rates that apply to capital gains often depends on the holding period, which begins the day after the acquisition of the property and ends on the day of its disposition or sale. If the property was held for 1 year or less, then this disposition is considered a short-term capital gain or loss, which is treated as an ordinary income or loss. For property held longer, the disposition results in a long-term capital gain or loss, which usually receives better tax treatment. The holding period for patents and inherited property is considered long-term regardless of how long the taxpayer actually held the property. For an installment sale, if the gain was long-term in the year of the sale, then all succeeding payments will also be treated as long-term gains; otherwise, all installment payments will be considered short-term.

Netting Capital Gains with Capital Losses or up to $3,000 of Other Income

Although tax law always recognizes capital gain, it does not recognize losses for personal property — only for investment or business property. The losses of personal property cannot be used to offset any capital gains, including from other personal property. When offsetting other income, short-term losses must first be used, then long-term losses:

• When there is a combination of capital gains or losses, the gains or losses must be segregated as either short-term or long-term, and within asset categories, such as investments and collectibles, where the capital losses reduce the capital gains within the respective category.
• If there is still a net capital gain in 1 category and a net capital loss in the other, then the capital loss can be used offset the capital gain.
• If, after netting all capital gains and losses, there remains a capital loss, then the loss may be used to offset up to $3,000 of other income. For married couples filing separately, capital losses can only offset up to $1,500 of each spouse's income. However, a spouse can only offset her own income with her own losses.
• Any remaining losses can be carried forward indefinitely as loss carryovers. However, loss carryovers retain their time character, so a short-term loss carried forward is a short-term loss; likewise, for long-term loss carryovers. In a joint filing, the $3,000 limit applies to the combined gains and losses of both spouses. The taxpayer should keep records of all loss carryovers.

If the taxpayer dies with losses carried over from prior years that exceed the $3,000 limit ($1,500 limit for married filing separately), then the losses cannot be used to offset any capital gains either by the taxpayer's estate or by the surviving spouse. The IRS has held, however, that the net capital loss of a dead spouse may be claimed by the surviving spouse on a joint return that is the final return for the dead spouse.

Generally, capital losses are not allowed on dispositions of property between related parties, including ancestors and descendants, and siblings, whether whole or half blood. Losses are also disallowed between taxpayers and legal entities, such as a corporation, where the taxpayer has a controlling interest, including interests shared by family members or other legal entities where the taxpayer or his family members have a controlling interest. However, if a loss was disallowed between related parties and if the acquiring party resells the property at a profit, then the disallowed portion is not taxable.

How Capital Gains and Qualified Dividends Are Taxed

The tax treatment of the gain or loss depends on the type of property sold and the length of time that it has been held. Property sold in a given tax year, for which the seller will be receiving payments in later years, may report the sale as an installment sale, using Form 6252, Installment Sale Income, where the gain can be distributed over the installment period.

Capital assets are reported on Form 8949, Sales and Other Dispositions of Capital Assets. Part I lists short term gains or losses and Part II lists long-term gains or losses. The taxpayer may also receive Form 1099-B, Proceeds from Broker and Barter Exchange Transactions from brokers showing the taxpayer's basis in the security sold, which determines the net profit. The calculations on Form 8949 are transferred to Schedule D, Capital Gains and Losses of Form 1040, where short-term and long-term gains or losses are combined to yield a net gain or loss. If the only source of capital gains or losses is mutual funds or real estate investment trusts, then Schedule D is unnecessary. The capital gains or losses from a pass-through entity, such as a partnership, S corporation, estate or trust are reported on Schedule K-1, the results of which are transferred to Schedule D. However, C corporations pay the same rate on capital gains as for ordinary income.

For years, the long-term capital gains rate was a flat rate of 15%. In 2011, the flat rate was replaced with a marginal rate of 0% and 15%, and in 2013, an additional marginal rate of 20% has been added. Although the lower marginal tax on capital gains only applies to long-term capital gains, the income level is determined by the taxpayer's total taxable income. The same rates also apply to qualified dividends, which are taxed as long-term capital gains. Other long-term capital gains may have maximum rates of 25%, or 28% depending on the type of property.

The new Republican tax policy, passed at the end of 2017, known as the Tax Cuts and Jobs Act, has changed the tax brackets for 2018 and afterwards, but the qualified dividend rate of 0% still applies roughly to the lowest 2 income tax brackets, which under the new law is the 10% and 12% brackets. The income threshold for the 20% bracket, which corresponds to the upper portion of the 35% bracket and entirely to the new tax bracket of 37%, has also increased.

Long-Term Capital Gains Rate Depends on Income

The long-term capital gains rate depends on income brackets with different ranges than for earned income:

Additionally taxpayers with income above certain thresholds will also owe the Net Investment Income Tax (aka Medicare surtax) of 3.8% on all their investment income, including long-term capital gains:

So taxpayers who must pay the higher 20% capital gains rate will also have to pay the 3.8% Medicare surtax, yielding a total tax rate of 23.8% on long-term capital gains. Upper-income taxpayers in the 15% capital gains bracket will also have to pay the 3.8% surtax, for a net tax of 18.8%. Note that the 3.8% surtax also applies to short-term gains, that, when combined with the new top rate of 37%, yields a top tax rate of 40.8%.

To receive the preferential tax treatment for long-term capital gains, the taxpayer must use the Qualified Dividends and Capital Gains Tax Worksheet in the Form 1040 instructions. Any capital asset subject to the 28% rate or unrecaptured §1250 gains subject to a 25% rate must be calculated using Schedule D Tax Worksheet in the Schedule D instructions.

The amount of qualified dividends or long-term capital gains where the 0% rate applies = the 15% bracket minus the taxpayer's ordinary income. Note, that, starting for tax year 2018, the tax brackets have changed, so the 0% rate will apply to the 12% bracket or lower. The upper income limit for these brackets depends on filing status and is indexed for inflation:

Children subject to the kiddie tax may not use the 0%, 15%, or 20% tax rate if their parents' applicable rate is higher.

However, higher income taxpayers may still benefit from the 0% rate, if their ordinary income without the qualified dividends or net capital gains is less than the 0% upper limit; then the taxpayer can use the 0% rate on that portion of the investment income that exceeds the income from other sources but less than the 15% tax bracket. The 20% bracket is treated similarly.